Category Archives: markets

Michael Lewis has written a gripping and penetrating book about high frequency trading and the current state of U.S. equity markets. Lewis, of course, knows how to tell a good tale, so the book is fun to read. But the big payoff is insight. The book is astonishingly good at crystallizing what’s going on and why.

Flash boys is all about stock markets, where the accidents of history happened to have spawned a particularly freakish evolution of automated trading. Derivatives markets have only a cameo role through the geographic placement of stock futures in Chicago. In the news frenzy following the book’s release, securities regulators have put out obligatory releases meant to tamp down public anxiety. According to Silla Brush at Bloomberg, the CFTC’s Acting Chairman Mark Wetjen was among them:

“I don’t have the impression at the moment that futures markets are rigged.” The CFTC and its enforcement division are reviewing trading practices in the futures market to ensure they aren’t manipulative, Wetjen said. The agency is also reviewing relationships between exchanges and trading firms, he said.

Hopefully, the reviews Chairman Wetjen is referring to are substantive. Insiders know that the issues at hand in Flash Boys are all too pertinent to derivatives markets. The precipitating event underlying the story is technological change. The drama is in how social forces negotiate that change. Nothing distinguishes derivatives markets from equity markets in the grand scheme of things. But, more accidents of history did initially immuniz derivatives markets from some of the ugliest practices detailed in Lewis’ book. But derivatives markets are undergoing a major restructuring in the wake of the 2008 financial crisis, and that restructuring undermines some of that immunity. So it is vitally important that the CFTC take full advantage of the breathing room it has in order to harness technology in the service of vibrant markets serving the productive economy. Otherwise, the confluence of these two streams—derivatives reform and technological change in trading—could prove treacherous.

The U.S. derivatives watchdog on Monday chided the industry for providing gappy data on the $630 trillion market… “I do want to get away from the handholding,” said Vincent McGonagle, the CFTC’s head of the Division of Market Oversight. “It is clear that there are issues where parties are not reporting,” he said.

What is he talking about?

I’m guessing that this is an example. ICE Trade Vault is a Swap Data Repository for commodity products, including financial power. In addition to running its data repository, ICE is a lead platform for trade in these products. According to data compiled by one of its platform competitors, Nodal Exchange, and provided to the CFTC’s Division of Market Oversight, the data feeds from ICE Trade Vault lack some of the most pertinent information about transactions:

…of the 33,030 financial power transactions reported by ICE Trade Vault in 2013, we found that 21,054, or 64% were listed as “exotic” and lacked basic transaction information such as the unit of volume and the product transacted. Furthermore, only 11,973 transactions, or 36%, of all financial power transactions reported by ICE Trade Vault contained any price information.

We were also dismayed to see that for even the relatively well described transactions denominated in Megawatt Hours (MWh) reported by ICE Trade Vault, the vast majority (11,214 of 11,893 transactions, or 94.5%) had, at best, only a generic region or Regional Transmission Operator (RTO) or Independent System Operator (ISO) identified. We believe this lack of specificity is largely unwarranted. For example, many transactions reported by ICE Trade Vault simply show “PJM”, a Regional Transmission Operator covering all or parts of 13 states plus the District of Columbia. However, on ICE Futures U.S., ICE offers futures contracts covering 13 distinct zonal locations and four hub locations within PJM, providing a ready basis for more specific locational reporting for ICE Trade Vault as well. Financial power information is really only useful if it conveys what product is traded (specific power location), at what price, and for what volume. This information is available on only 607 of the 33,030 financial power transactions, or 1.8%, as reported by ICE Trade Vault.

Trade reporting is the law, but there is obviously a long way to go before its a reality.

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What are the costs and benefits of the reform of derivative markets now taking place? A report released last week by the Bank for International Settlements (BIS) pegged the central estimate of the benefits at 0.16% of annual GDP.[1] With US GDP at something more than $15 trillion, that’s $24 billion annually. For the OECD as a whole, the figure is nearly triple that.

Approximately 50% of the benefits are due to the push to central clearing. Continue reading →

During last year’s debate about the Volcker Rule, Morgan Stanley commissioned a study by the consulting firm IHS that predicted dire consequences for the U.S. economy. I called the study a hatchet job. My main complaint was that the study made the obviously unreasonable assumption that the bank commodity trading operations would be closed down and not replaced. IHS even excluded the option of having banks sell the operations.

US private equity group Riverstone is leading talks on an investment of as much as $1bn in a new commodities investment venture to be run by a former Deutsche Bank executive…

Morgan Stanley is considering a sale or a joint venture for its commodities business… James Gorman, Morgan Stanley’s chief executive, last October said the bank was exploring “all form of structures” for its commodities business.

Glenn Dubin, Paul Tudor Jones and a group of other commodity hedge fund investors last year bought the energy trading business from Louis Dreyfus Group and Highbridge Capital, the hedge fund owned by JPMorgan Chase. The parties later renamed the business Castleton Commodities International.

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Last week the OTC swaps market took a big step towards the creation of standardized interest rate swaps. Pushed by the buy-side, ISDA developed a “Market Agreed Coupon” or MAC contract with common, pre-agreed terms. From the ISDA press release:

The MAC confirmation features a range of pre-set terms in such areas as start and end dates, payment dates, fixed coupons, currencies and maturities. It is anticipated that coupons in the contract will be based on the three- or six-month forward curve and rounded to the nearest 25 basis point increments. Effective dates will be IMM dates, which are the third Wednesday of March, June, September and December. The initial currencies covered include the USD, EUR, GBP, JPY, CAD and AUD. Maturities will be 1, 2, 3, 5, 7, 10, 15, 20 and 30 years.

This is good for end-users. Dealers have long used superfluous customization as a tool to blunt competition and maintain margins. Creating a subset of contracts with standardized terms will make the interest rate swap market more efficient in many ways.

Some in the industry worry this just feeds the trend to futurization of swaps:

“It’s quite speculative to try to figure how this will turn out, but on the one hand a more standardised product is presented as more homogeneous, which is good for OTC markets, while on the other, you could argue the more a product is standardised, the less differentiated it is from futures and ultimately could lose out to straight futures activity,” says one New York-based rates trader. “I think there is a fear that this standardisation process creates a much easier path towards futurisation. You could argue this is one step closer towards promoting the success of swap future contracts.” (RISK magazine, subscr. required)

But that ship had already sailed. The G20 specifically rejected the old model of faux customization, and mandated standardization in support of improved transparency and clearing. Whether standardization happens within the OTC swaps space, or via futurization is a detail.

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Companies that hedge oil prices have been forced to reevaluate their strategies over the last couple of years. Many companies have used the NYMEX WTI contract, one of the oldest energy futures contracts and still one of the most liquid. The WTI contract is for oil delivered into Cushing, Oklahoma, but since crude oil is a global commodity and transportation links have historically been good, fluctuations in the WTI price have been a reasonable benchmark for global supply and demand.

However, in the last few years, the differential between WTI and Brent, the other leading global benchmark, have exploded and been very volatile. Suddenly, geography made a great deal of difference. Technology has opened up new production in North America, first from the Canadian oil sands and more recently from US tight oil fields. A bottleneck in the capacity of pipelines for shipping production out of Oklahoma down to the US Gulf Coast meant that the central US experienced a glut of supply, disconnecting the regional price from the global one.

This has meant that fluctuations in NYMEX’s WTI futures price reflected local variations in demand and supply that did not necessarily track variations in global supply and demand and global crude price. Hedgers not located in the central US faced increasing basis risk in using the WTI contract. Some switched to using the ICE Brent contract instead. Others adjusted their hedge ratios. These events have been a key feature of the recent marketing duels between NYMEX and ICE over which contract is best.

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Natural gas prices have been rising recently. But I always like to look at the whole term structure of futures prices to get a better sense of what is really going on. My colleagues at CRA, Billy Muttiah and James Dunning, prepared this chart which overlays snapshots of the term structure at the start of the last several months. It tells a simple story.

What’s going on is mostly a story about the long-run. Only a small amount of recent spot price changes are due to short-run factors and changes in the spot vs. futures price. Prices at all maturities have been going up. And the shifts are roughly parallel throughout the term structure.

A quick look like this doesn’t clarify whether it is long-run demand shocks, long-run supply shocks or any number of other combination of factors. But it does focus attention in the right place.

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About this blog

We use this blog to discuss with our students issues in risk management for non-financial corporations. The blog addresses interesting events in the news, as well as advances in financial analysis. We have made the blog public to encourage valuable contributions from former students, colleagues and others in industry, government and academia.

The content of the blog is closely aligned with the material in our lecture notes on Advanced Corporate Risk Management (MIT course 15.423). A website with the notes and associated materials will be coming soon.